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Explore how consumers change their buying habits when prices fluctuate and learn to calculate the elasticity coefficient.
Why can a gas station hike prices by 20% and keep almost every customer, while a coffee shop doing the same might go bankrupt in a week?
In economics, Price Elasticity of Demand (PED) measures how much the quantity demanded of a good responds to a change in the price of that good. Think of it as the 'stretchiness' of consumer behavior. If a small price increase causes a massive drop in sales, the demand is elastic (like a thin rubber band). If a large price increase barely changes sales, the demand is inelastic (like a heavy-duty cable). Because price and quantity move in opposite directions (Law of Demand), the resulting number is technically negative, but economists typically use the absolute value for simplicity.
Quick Check
If a 10% increase in the price of a digital movie rental leads to a 30% drop in rentals, is the demand for that movie elastic or inelastic?
Answer
Elastic, because the percentage change in quantity (30%) is much larger than the percentage change in price (10%).
To calculate elasticity precisely, we use the Midpoint Formula. Standard percentage change math gives different results depending on whether the price is rising or falling. The midpoint method solves this by calculating the change relative to the average of the old and new values. The formula for the elasticity coefficient is:
This ensures that the elasticity between Point A and Point B is the same as the elasticity between Point B and Point A.
A pizza shop raises the price of a large pie from 12, and sales drop from 100 pies to 80 pies per day.
Once you have your coefficient , you can classify the demand curve: - Elastic (): Consumers are highly sensitive. Total revenue falls if you raise prices. - Inelastic (): Consumers are insensitive. Total revenue rises if you raise prices. - Unit Elastic (): The percentage change in quantity perfectly offsets the percentage change in price. - Perfectly Inelastic (): A vertical line; quantity demanded doesn't change regardless of price (e.g., life-saving insulin).
Quick Check
If the calculated elasticity coefficient for a luxury handbag is 2.5, what happens to total revenue if the company lowers the price?
Answer
Total revenue will increase because the demand is elastic (), meaning the gain in customers will outweigh the lower price per unit.
Why are some goods more elastic than others? Four factors usually decide: 1. Availability of Substitutes: If there are many alternatives (e.g., different brands of cereal), demand is elastic. 2. Necessities vs. Luxuries: Insulin is a necessity (inelastic); a yacht is a luxury (elastic). 3. Definition of the Market: 'Food' is inelastic (no substitutes), but 'Haagen-Dazs Vanilla Ice Cream' is highly elastic. 4. Time Horizon: Demand is more elastic over long periods as consumers find ways to adapt (e.g., switching to electric cars when gas prices stay high).
Imagine a city where the only bridge into town raises its toll from 8. In the first week, traffic drops by only 5%. However, a year later, traffic has dropped by 25% as people started carpooling or moved closer to work.
1. Short-term Elasticity: change is small (5%) relative to change (60%). Demand is highly inelastic. 2. Long-term Elasticity: change (25%) is much larger. 3. Conclusion: This demonstrates the Time Horizon determinant—consumers are more price-sensitive when they have time to change their habits.
Using the midpoint formula, if price rises from 60 and quantity falls from 120 to 80, what is the elasticity?
Which of the following would likely have the most INELASTIC demand?
If demand is elastic, a price increase will lead to a decrease in total revenue.
Review Tomorrow
In 24 hours, try to write down the Midpoint Formula from memory and explain why we use the average of the two points instead of just the starting point.
Practice Activity
Pick three items in your room. For each, identify one substitute that would make you stop buying that item if its price doubled.